PrintExchange traded funds are the newest flavor on the investment board today. Ironically, those who snickered at the lack of "adventure" offered by an index fund are now lining up to buy the stock equivalent.
Established in 1993, ETFs present investors with an interesting hybrid of index mutual fund and common stock. They follow an index such as the S&P 500 but are easily tradable on a stock exchange.
The advantage of having instant diversity in one purchase on the stock exchange is appealing to many investors. And, in the fast-paced world, ETFs can also be traded instantly at real-time rates, unlike mutual funds, which trade at the net asset value set the previous day. While the purpose of mutual funds is not day trading, that option is available for an ETF investor should there be a significant shift in the market. Other similarities to stocks include the fact that an ETF can be bought on margin and traded using a stop order or limit order, which lets investors specify the price points at which they are willing to trade. ETFs are also more liquid than mutual funds.
Besides the great diversification that ETFs bring, particularly since they cover an entire index, ETFs (like all index funds) have very low expense ratios because there is little trading activity compared to managed funds.
However, a concern of ETF investors is the commission charged on every transaction. You won't find no-loads as you'll find with mutual funds, which can be purchased by dialing a toll-free number. ETFs are purchased through brokerage houses, and unless someone is investing major amounts of money, the transaction fees can take a big bite out of a typical ETF return on your investment.
In fact, the Morningstar Cost Analyzer compared the annualized returns of a $10,000 investment (with $100 monthly contributions over 10 years) in The Vanguard 500 fund and the SPDR 500 (ETF), both of which track the S&P 500. While the annual returns were equal because they track the same index, and even with the SPDR having a lower expense ratio, the index fund had better results than the ETF because of the transaction fees charged by the ETF (even presuming the use of discount brokerage houses).
In the all-important tax arena, the ETF essentially is similar to the tax-managed index mutual funds. Since most of the tax bite in mutual funds comes from the capital gains realized by trading within the fund, there is an advantage inherent in the lack of trading that index funds and ETFs offer. This will typically make index funds and ETFs more favorable from a tax perspective than actively managed mutual funds. Also, of benefit from a tax standpoint is that most of the capital gains tax generated by an ETF can be paid when the ETF is sold, as is the case with a stock. This allows for easier tax planning.
By determining your future goals and looking closely at the expense ratio, commission fees, and your own tax situation, you can sit down with your broker, financial advisor, planner, or CPA and determine whether ETFs or index funds are right for you.
